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Stargazing

The Art of Forecasting the Financial Future

by James J Puplava CFP, President & CEO, PFS Group. January 11, 2002

Our Need To Know

The markets love certainty and so do individual investors. When trends are predictable, investment decisions are easier to make. A trend firmly established is easier to ride than one that is constantly changing. The financial markets prefer to travel along a straight road more than one that weaves and winds in unpredictable fashion. The problem for investors is that the world we live in isn't always predictable. The world changes and so do the financial markets. A boom can turn into a bust and a bull market can turn into a bear market. Nature itself is constantly changing from season to season. The essence of a living organism is movement. The same is true with the financial markets.

In an effort to bring certainty to our world and financial markets, we rely on forecasts. We have weather forecasts, election year forecasts, financial forecasts and even sports forecasts. The purpose of these forecasts is to lend a sense of assurance in a world that is unpredictable. It has been that way throughout human history. From emperors and kings to prime ministers and presidents, leaders and their followers have relied on forecasts to guide them in their decision making. In the old days, forecasters were called oracles, soothsayers, prophets and seers. Today we have come to know them as weathermen, pollsters, economists and analysts. Their job is to predict the future when the future itself is unknowable. They take uncertainty and by their forecasts make that uncertainty certain.

More of The Same

So here we are again at that time of year when the soothsayers and oracles look into their crystal balls and tell us mortals what lies ahead. Given all of the events of last year, those forecasts have become even more important. Last year was full of many unexpected shocks, September 11 being one of them. The markets didn't go up, the economy went into recession, corporate earnings didn't recover, and we are now at war. The world and the financial markets didn't follow the script that was written at the beginning of last year. Now the world and financial markets are filled with doubt and ambivalence. Skepticism is everywhere. The forecaster's job is even harder this year because there is a general unease in the land. The terrorist attacks on America have now created an insecurity that didn't exist before. The financial markets have gone down two years in a row and portfolios are still hemorrhaging. Hope is still alive and most people, including investors, are looking to the oracles to tell them, "Better times lie ahead."

It is this blind faith in the power of the oracle that has kept the markets from falling into the abyss. General public confidence is still running high despite a plethora of bad news on the economy. Earnings are still going down, companies are still restructuring and laying off workers and we are still at war. Optimism remains high because the oracles tell us things are going to get better. Government spokesmen tell us the war will be won and economists and analysts tell us the economy and the financial markets will recover.

It seems the forecasts for this year are the same as last year. The seers tell us their predictions were only off by one year. So, this year's forecasts are indeed the same as last year. Namely, they are once again prognosticating a better second half of the year. Further, they estimate that by the end of the second quarter, the economy will be out of recession, corporate earnings will be growing at double digits again, and the financial markets will start another bull run. This seems to be the prevailing consensus.

Economics has been called a dismal science and for good reason. Forecasters failed miserably last year to predict the speed of the downturn or another bad year for corporate earnings and the stock market. Economists predicted 3% economic growth. Instead of growth, we got a recession. No one predicted that the world's three largest economies, the U.S., Japan, and Germany, would go into recession. Wall Street failed just as miserably by predicting another year of gains for stocks. In place of gains, we have had two consecutive years of losses. Analysts overestimated earnings and as a consequence, predicted another year of gains for the stock market in 2001. All three major averages suffered single to double-digit losses.

There should be no surprises here. When it comes to predicting earnings or recessions, analysts and economists have a poor record when it comes to accuracy. Most forecasts are based on long-run trends. Whatever happens in one year is usually extrapolated into the next year. Moving averages and regression analysis is used to smooth out irregularities. It makes estimates look reasonable, but provides little insight when powerful forces are about to disrupt the prevailing trend. Forecasters tend to move in a pack and seek consensus in their predictions. Very few want to stand out by going against the crowd. There is a certain sense of job security when you are wrong along with everybody else.

Source: Wall Street Journal

Despite their inaccuracies, forecasts still garner attention in the media. Just go to your local book store and what do you see? You see shelves filled with newspapers and magazines telling you with a solemn degree of certainty what we all know is uncertain. The value given to these forecasts is far below the fascination and attention that is given to them. They are held in high regard because they make us feel better about the future by making that future predictable. Even though they are often wrong, people want to believe in them. We can't blame the forecasters. We can only blame ourselves.

Forecasts are useful only in the sense they help to clarify our thinking. They help us to focus on the various elements of the economy and at best, identify risk. They are tools that should stimulate our thinking, but are dangerous when they are taken literally.

Consensus and Extremes

As we focus our thinking on this year's batch of predictions, we find that there are three major trains of thought pervading the financial world. The consensus is for an economic recovery that will begin in the second half of the year. Further, economic growth will be low and it will begin gradually. I call this forecast "The-Middle-of-the-Road & Consensus View." On the extreme sides of this year's forecasts are "The Gloom & Doom" and "Boom" forecasts. The gloom and doom forecast predicts that the U.S. economy will fall into a liquidity trap similar to Japan with a protracted economic slump and a long-term bear market. On the opposite side are the cheerleading camps on Wall Street and in the financial media. This is the sunny sky and rose-colored glasses scenario. They are predicting the same thing that they have been predicting for the last two years: rising earnings and booming financial markets. They are urging investors to load up on stocks because they are cheap. They believe that there are no clouds on the horizon and an economic boom lies directly ahead of us. The trouble is that their rose-colored glasses prevented them from ever seeing any of the clouds when they appeared last year or the ones that still lie above us today.

THREE ECONOMIC DRIVERS TO RECOVERY

When we look at the recovery scenario, it is important to understand what will lead us out of recession. The economy is made up of consumer spending, capital investment by business, and government spending. What made this recession unusual is that consumer spending and housing remained strong throughout the recession thanks to low interest rates engineered by the Fed flooding the financial system with money.

Driver #1 Consumer Spending

Federal Reserve actions (interest rate manipulation and printing money) are in large part responsible for what has kept housing strong and consumer spending at high levels. Lower interest rates have allowed consumers to refinance debt, which in turn, freed up capital and income for more spending. In fact, consumers continue to pile on more debt as a result of zero percent financing available on autos and low mortgage rates. In the latest report, U.S. consumer borrowing surged by $19.8 billion in November. Non-revolving credit, which includes auto loans, surged during the month. The swell in borrowing was the highest rate in almost six decades. Money is free or cheap and consumers are taking full advantage of easy credit. Credit card debt continues to grow with $5.4 billion added to consumer balance sheets in November. Household debt levels are now higher than the last recession.

Unlike past recessions where debt was liquidated, this time around debt was accumulated. In the last recession, the average American pared down debt by $410. In this recession, the average household added $1,420 of new debt. As these graphs indicate, debt burdens have continued to rise. The flow of cheap money provided by the Fed has allowed Americans to buy bigger homes, cars, and big-ticket items that have helped to bolster the sagging economy. Total consumer debt hit a record $7.5 trillion by the end of the third quarter of 2001. Lenders have kept the tap wide open, just as the Fed intended. However, those debt levels pose a real danger to the economy if it doesn't improve. By taking on more debt, more of the household budget will be directed towards servicing that debt. This debt service takes away from future spending. What this means is that an important element of a recovery, which is a big boost in consumer spending, will not take place. Consumers will now be forced to divert a greater share of income away from spending as debts are repaid. This takes money away from future consumption removing an important stimulus to the economy.

Companies from automakers to financial lending firms are still feeding the debt frenzy. Everyone wants to lend you money to buy things from Ford and GM to Home Depot and Sears. There is a plethora of attractive financing deals to choose from in order to entice you to spend and borrow. No one has any qualms about borrowing anymore. The government is encouraging it and portraying it as a sign of patriotism with do your part for America by borrowing and spending. During the holidays, I was amused by an advertisement at the entrance of a consumer electronics store. The message was "Strike back at the terrorist by spending money inside. Easy credit terms available."

The only problem with easy credit is that it creates debt problems down the road. Needless to say, our nation's credit counselors are busy and putting in overtime. At some point, that debt must be paid back. The weight of all that debt will eventually overwhelm the consumer with financial stress and lead to bankruptcy. The important point here is that a key stimulus to the economy's recovery will be hindered because it was never cleansed in the last recession. Instead of paying off credit and rebuilding savings, thereby setting the stage for recovery, debt was piled on debt. Unfortunately, this will prevent a burst of activity and stimulus from the consumer sector, making it difficult for the Fed to engineer an enduring recovery.

Driver #2 Capital Spending

This leads us to the next economic pillar which is capital spending. What has made this recession unusual from past recessions was that it was led by businesses in a profit-led recession. Companies cut spending viciously as profits evaporated. The key difference between the last recession and this one is that profits never declined during the last downturn and they soared when the economy recovered. Not this time around. Company income and balance sheets are still hemorrhaging. Profits have fallen faster than company cost cutting, which has led to a financing gap. The Federal Reserve reports that the financing gap (the excess of capital spending over cash flow) stood at near record levels at the end of 2000. By the third quarter of last year, that figure amounted to $250 billion. U.S. companies, like consumers, are continuing to add and take on debt. As of the end of the third quarter, the Fed reported that nonfinancial debt stood at a record $4.9 trillion. What is occurring at the corporate level mirrors household budgets. It has been mainly the increase in debt that has accounted for the big drop in corporate earnings outside the write down of goodwill.

It is hard to imagine a capital led spending boom when profits are still plunging. At the current moment, the bust in capital spending remains the economy's primary depressant. The daily headlines are still filled with earnings disappointments, corporate restructuring, and job layoffs. As businesses continue to lose money they are continuing to cut capital spending plans aggressively. As cash flow falls, companies have to tap the financial markets for even more money. This is leading to more stress in the financial system as more companies file for bankruptcy protection. Debt downgrades are on the rise by a 3-1 margin over debt upgrades.

This increase in corporate debt is making the forecast of a capital led spending boom a distant reality. The Fed is resorting to a massive monetary stimulus in order to keep the private sector afloat. To some extent, it has been successful in keeping the economy from falling into the depths of a severe recession. But by flooding the markets with liquidity and making credit amply available, it is preventing the cleansing process that normally occurs in a downturn. This will make it more difficult to engineer a robust recovery. There isn't any pent up demand at the consumer and corporate level. Debt levels still remain high which will crimp future spending plans by both consumers and businesses.

Driver #3 Government Spending

With no pent up demand coming from the consumer and corporate sectors, the strength of any economic recovery is now resting on government spending plans. The Fed has taken the economy as far as it can with real interest rates below zero. The massive monetary expansion has probably taken us into the beginning stages of a recovery. It is the second stage that is now of big concern. This is where the stimulus package comes in. Without it, the economy could very easily slip back into recession. There are just too many imbalances created by the bubble economy of the 90's. The tech sector is still suffering from over capacity. Inventories are coming down, but remain high. Debt levels are rising, savings are nonexistent, portfolios are still losing money and confidence is tentative. The President is pushing for lower tax rates and new spending plans. Congress is more than eager to add plenty of pork. Both sides can't agree. The Republicans want the tax cuts accelerated to provide cash and incentives for expansion. Democrats want new spending and transfer programs to help fill the void. There is a bit of Keynes imbedded in each side�s stimulus package in that both parties are aiming at increasing consumption.

My Forecast: Mediocre & Unexpected

What is missing from the various forecast equations are debt imbalances, leverage in the financial system, lack of savings, over-valued stock prices, the trade deficits, and the dependence on foreign capital. The failure in the debate to address these imbalances shows how little understanding there is of the economy in Washington. Because of these instabilities, it is hard to conceive a robust recovery anytime soon. What is more likely to happen is that we get a weak recovery with a very distinct possibility of a double-dip recession. The real question that needs to be asked is, What will lead us out of a recession? Will it be debt-driven consumer spending or a capital spending spree by debt-laden corporations whose profits are plunging? Or will government spending replace consumption by consumers and investment by business?

The economic risks are high, but so too are the financial risks. The one thing that is not anticipated by economists and analysts in their financial forecast is the unexpected events. These are the rogue waves that lurk beyond the horizon. They can appear out of nowhere and suddenly create havoc and destruction. Interestingly rogue waves usually come in sets. When one appears, they are usually followed by others. There is no room for another 9-11. Looking at the economic and political landscapes around the world, there are plenty of wild cards that could throw any forecast off course. I'll name just a few. Any one of them could be a confidence shaker.

Japan's Economy
The Derivative Book of U.S. Banks and Brokerage Firms
The Middle East
The War Against Terrorism
Emerging Market Economies in Argentina, Turkey, & Asia

It is the possibility of another rogue wave this year that poses the greatest risk to the economy and the financial markets in the U.S. The U.S. economy has already withstood one rogue wave and survived, but the ship's bulkheads have been weakened. The ship isn't strong enough to withstand another series of rogue waves. It is important to realize that what happened in the 90's was a bubble which is in the process of deflating. Monetary authorities are making a valiant effort to reinflate it. Downside risks are everywhere. That is why investment strategies should remain conservative and investors should remain on high alert.

Telltale signs and strategies to follow in the weeks ahead. ~ JP

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